Pre-Judgment Interest, Part III: Property Damage, Profit, and PJI

My practice involves a lot of work for property insurance companies. When damage to property occurs, the property owner may advance a claim against the third party tortfeasor for both the value of the damaged property as well as an ongoing loss of income or profit associated with the damage. While most first party business interruption insurance policies will typically limit any claim for lost profits to a 12-month period from the date of incident, third party claims for lost profits can often extend outside of this period.

In such cases, not only will there be damages claimed for both the physical damage and lost profits; there will also claims for pre-judgment interest. This post looks at how pre-judgment interest should be calculated in such situations.

In my experience, pre-judgment interest is often awarded on the property damage as well as on the lost profits. Is this correct from a financial point of view? Consider that lost profits represent a rate of return that would have been earned on the damaged property. If the plaintiff is already being awarded a rate of return on its lost property, it would seem unfair to also award it with pre-judgment interest on that same asset.

An Example

Consider the following example, which should illustrate this basic point:

Assume that ABC Corp. (“ABC”) has a single machine, which will cost $1M to replace in Year 5 and would have cost $900,000 to replace in Year 1.

The machine allows ABC to generate profits of $100,000 per year (we will ignore taxes for the sake of this example).

The machine is destroyed in a fire at the beginning of Year 1; the fire was caused by faulty electrical work performed by a subcontractor, and liability is admitted***. Due to lack of funds and other logistical issues, the plaintiff was unable to replace the machine until the end of Year 5; once the machine is replaced, it is not anticipated that ABC will suffer any ongoing adverse effects.

***It is great how financial experts always get to assume liability is a non-issue in their examples, isn’t it? Nothing to it…

It is now the end of Year 5, and the trial has just concluded. The trial judge has awarded the plaintiff the replacement cost of the machine, which is $1M, as well as lost profits of $500,000 representing five years of lost profits.

In addition, ABC will likely receive pre-judgment interest (for a five-year period) on the value of the machine, as well as interest on each year’s annual lost profits. Let us assume that the judge has decided to apply a simple interest rate of 5%, based on the rates specified in the Courts of Justice Act for the relevant date of loss.

The award may look something like this: the end result is a damages award of $1.5M and pre-judgment interest of $312,500.

But there are two problems with this calculation, both of which will tend to overstate the pre-judgment interest award.

First, the replacement cost of the machine has been calculated in Year 5 dollar terms; the replacement cost in Year 1 was only $900,000, but due to inflation the price of the same machine has increased by around 11%, to $1M. Pre-judgment interest rates include an inflation component; banks (including the Bank of Canada) lend money in the anticipation that inflation will occur, and they need to recover the erosion in the nominal value of the principal as part of their interest payments. If the property damage award already includes an adjustment for inflation, then compensating ABC for inflation a second time (through the pre-judgment interest mechanism) will result in a windfall to ABC.

But there is a second, somewhat less intuitive problem with the award.

Pre-judgment interest is meant to compensate the plaintiff for the loss of return on its assets during the interval between the date of the loss and the trial date. Yet that is precisely what the award for lost profits represents – the loss of the annual return on the machine that would have been earned by ABC. By awarding both pre-judgment interest and lost profits resulting from the destruction of the machine, we are essentially double-counting the plaintiff’s lost returns on its machine.

Both of these problems can be easily illustrated by modeling the plaintiff’s cash flows “but for” the destruction of the machine. The plaintiff would have earned $100,000 per year, which it would have (presumably) reinvested and used to earn additional returns. These additional returns can be modelled with pre-judgment interest (notwithstanding the issues I raised in previous posts, which argue that such rates tend to undercompensate plaintiffs). It is these cash flows that will need to be replaced.

In addition, but for the wrongdoing, the plaintiff would have still had the machine; but now it does not. It therefore needs to receive an amount that will allow it to buy a replacement machine in Year 5; it needs only $1M to replace the asset, not $1M plus interest.

As you can see, our damages award is still $1.5M, but we no longer accrue any additional amounts for pre-judgment interest for the damaged machine; PJI falls from over $312,500 to only $62,500. The combined award will put ABC back in the position it would have been in but for the destruction of its machine.

Conclusion

Property damage and lost profits are commonly viewed as two distinct heads of damage, and in some senses they are indeed separate: property damage occurs at a point in time, while lost profits are the consequential result of that physical event.

But failure to recognize the linkages between property damage and lost profits can result in damages assessments that are significantly distorted. There are many senses in which this is true, and I hope to delve into this area in a future post, but the area of pre-judgment interest is one example in which failure to account for these linkages can result in an inflated overall award.

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